Assessing leveraged loan credit spreads so far in 2014

While changes in interest rates may not prompt long-term investors in safe companies like Apple Inc. (AAPL) and Exxon Mobil (XOM) to react, investors holding stocks of highly leveraged companies may want to evaluate their holdings.

Leveraged loans have also experienced an increase in fund flows as investors moved their funds from low-yielding Treasuries elsewhere. Since both high-yield bonds and leveraged loans offer high interest rates, investors are primarily divided between the two on the basis of the risk they’re willing to take. Investors demand higher yields from high-yield bonds vis-à-vis leveraged loans, as high-yield bonds are unsecured, whereas leveraged loans are secured by a charge on the issuer’s assets. Consequently, the credit risk attached to high yield bonds is greater.

However, leveraged loans are loans issued to individuals or corporations with a considerable amount of existing debt, and they also have to compensate for the default or credit risk associated with repayment by paying higher yields.

The chart above shows how credit spreads for leveraged loans have evolved since the beginning of the year. The leveraged loan spread measured here is the difference between the S&P/LSTA U.S. Leveraged Loan 100 Index return and LIBOR, which serves as a benchmark for most leveraged loans.

The PowerShares Senior Loan Portfolio Fund (BKLN) is a popular ETF tracking the S&P/LSTA U.S. Leveraged Loan 100 Index. The Highland/iBoxx Senior Loan ETF (SNLN) and the First Trust Senior Loan ETF (FTSL) are other popular ETFs in the leveraged loans category.

The Fed funds rate has been zero on the lower bound for quite some time now. The Fed has deliberately kept the Fed funds rate at near zero so that its unconventional monetary policy, consisting of quantitative easing, is effective. This has also resulted in the LIBOR rate maintaining its low figure.

More than one factor have led to funds diverting toward the leveraged loan market.

The capital market has become yield-thirsty on account of Treasury bond yields also being at an all-time low. Investors are therefore diverting their investments towards leveraged loans in search of better yields.

With investor expectations of an interest rate rise, leveraged loans seem to be a safer bet, as they offer floating interest rates. Floating interest rate securities are preferable in a rising rate environment, as their return rises with the market. They’re effective in negating the effect of inflation or interest rate risk.

However, as leveraged loans are based on LIBOR, and LIBOR has been low for a while now, the yield on leveraged loans was also low. In a low interest rate environment, investors’ preference shifts towards fixed-rate high yield bonds. The outflow from leveraged loans has increased the liquidity risk attached to them, leading to an increase in the risk premium commanded by these securities. The increased risk premium has led to an uptick in yields, while LIBOR remains low. Consequently, spreads have risen since January.